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PFIC to CFC transition miniseries

This week is Part II in a miniseries devoted to examining different aspects of the PFIC rules as they apply to the following scenario:

On January 1, 2010, five individuals create a foreign startup company. Each person owns 20% of the value and voting power of the company. Two of the owners are US persons. Three of the owners are foreign.

Over several years, the company develops extremely valuable IP — it receives two separate offers of $9 million from other companies to purchase the IP, but does not accept the offers and continues the development.

It does not receive any income other than small amounts of interest income from its bank account (which contains approximately $1 million).

On June 30, 2014, one of the foreign owners sells his shares to a US person.

Last week, I discussed how the startup was a PFIC prior to the sale of 20% of the shares from the foreign person to the US person (named Lucky). On the day that Lucky bought 20% of the company, it became a CFC.

Lucky was never subject to the PFIC rules because the CFC-PFIC trump rule of IRC §1297(d) applied to him from the first day of his ownership in the company. He has a CFC only.

For the two US owners (Sally and David) who owned their shares prior to Lucky’s purchase, the company is both a PFIC and a CFC, unless they make a purging election to remove the PFIC status.

This week, I will provide some background, then talk about what happens when Sally makes a deemed sale election — how it is done and what the tax effects are.

Next week, I will talk about what happens when David makes a deemed dividend election — how it is done and what the tax effects are.

The company meets both definitions — CFC and PFIC

The company is a PFIC because it meets the income test of IRC §1297(a) — 100% of its income is passive. All it earns is interest income. Passive income for the purposes of IRC §1297(a) is defined in IRC §954(c), and includes interest income. The company only needs to meet one of the two tests described in IRC §1297(a) to qualify as a PFIC. Therefore the company is a PFIC.

A company is a CFC when more than 50% of its value or voting power are owned by US shareholders. IRC §957(a). “US shareholder” is a term of art that means a US person who has 10% or more of the voting power of a foreign corporation. IRC §951(b).

All the US persons who own shares in the startup are US shareholders because they have more than 10% of the voting power of the company. The company becomes a CFC when Lucky buys his shares on June 30, 2014 because it is 60% owned by US shareholders as of that day, and the threshold for CFC status is 50%.

The CFC status was triggered when Lucky bought 20% of the shares of the corporation on June 30, 2014. With respect to the income and asset tests of IRC §1297(a), however, the company is still a PFIC.

Does Sally own shares in a PFIC, a CFC, or both?

The startup is both a PFIC and a CFC for Sally

IRC §1297(d) says that a PFIC will not be treated as a PFIC for a shareholder during the period that the company is a CFC and the shareholder is a US shareholder of the company. The Code calls this the “qualified portion” of the holding period.

The company becomes a CFC on June 30, 2014. Sally is a US shareholder of the company. Therefore the company is not treated as a PFIC starting June 30, 2014…right?

Wrong. Regs. §1.1297-3(a) states the following:

A shareholder (as defined in § 1.1291-9(j)(3)) of a foreign corporation that is a section 1297(e) passive foreign investment company (PFIC) (as defined in § 1.1291-9(j)(2)(v)) with respect to such shareholder, shall be treated for tax purposes as holding stock in a PFIC and therefore continues to be subject to taxation under section 1291 unless the shareholder makes a purging election under section 1298(b)(1). A purging election under section 1298(b)(1) is made under rules similar to the rules of section 1291(d)(2). Section 1291(d)(2) allows a shareholder to purge the continuing PFIC taint by either making a deemed sale election or a deemed dividend election.

(A quick note to readers: Where these regulations refer to IRC §1297(e), they actually mean 1297(d) where the CFC-PFIC trump rule is found. This occurred because the regulations were written before IRC §1297 was renumbered and the language of the regulations was not updated to reflect the renumbering. See TD 9360; 72 FR 54820-54825; PL 110-172, §11(a)(24)(A); 121 Stat. 2486.)

Regs. §1.1291-9(j)(2)(v) defines a section 1297(e) PFIC as follows:

A foreign corporation is a section 1297(e) PFIC with respect to a shareholder (as defined in paragraph (j)(3) of this section) if—

(A) The foreign corporation qualifies as a PFIC under section 1297(a) on the first day on which the qualified portion of the shareholder’s holding period in the foreign corporation begins, as determined under section 1297(e)(2); and

(B) The stock of the foreign corporation held by the shareholder is treated as stock of a PFIC, pursuant to section 1298(b)(1), because, at any time during the shareholder’s holding period of the stock, other than the qualified portion, the corporation was a PFIC that was not a QEF. Reg. §1.1291-9(j)(2)(v).

Sally holds shares of a section 1297(e) PFIC, because before the company became a CFC, it was a PFIC, and she held shares of the company before it became a CFC. Therefore the CFC-PFIC trump rule of IRC §1297(d) is not automatic, according to Regs. §1.1297-3(a).

The excess distribution rules of IRC §1291 continue to apply until a purging election (either a deemed sale election or a deemed dividend election) is made. That means that if Sally does not make a purging election, the company will be treated as both a PFIC and a CFC for her, and she will be subject to both sets of rules simultaneously.

How the deemed sale election works

According to Regs. §1.1297-3(a), Sally may make either a deemed sale or deemed dividend election to remove the PFIC status and operate under the CFC rules only.

In this scenario, Sally will be making the deemed sale election. So how, exactly, does that work?

The deemed sale election as it applies to a shareholder of a section 1297(e) PFIC is described in Regs. §1.1297-3(b).

Under that regulation, the deemed sale will be treated as a disposition subject to taxation under IRC §1291 (meaning gains are taxed as excess distributions) on the date the company qualifies as a CFC. If there are losses on the deemed sale, they are not recognized. After the deemed sale, the stock will not be treated as PFIC stock anymore unless it ceases to qualify as a CFC but continues to meet the definition of a PFIC. Once you recognize gain under the deemed sale, your adjusted basis in the stock increases by the amount of the gain recognized. Regs. §§1.1297-3(b) and (d).

How to make the election on Form 8621

On Form 8621, Part II, Sally selects Election F, Election To Recognize Gain on Deemed Sale of PFIC.

Sally computes the gain as if she sold the stock on June 30, 2014. She enters the gain on Part V, Line 15f, and fills in Lines 16a-16f according to the excess distribution rules of IRC §1291.

Sally must file both Form 8621 and Form 5471 for 2014

In addition to filing Form 8621 to make the election and report the deemed sale, Sally also has to file Form 5471 for 2014 because the company is a CFC.

Effects of deemed sale election

The total value of the company (IP and bank account) is approximately $10 million. I will ignore the value of the laptops for the purposes of computing gain and tax on the deemed sale.

Sally owns 20% of the corporation. That means when she makes the deemed sale on June 30, 2014, she has a sale proceeds of $2 million. Assuming her basis in the corporation is $200,000, she must recognize a gain of $1.8 million under the excess distribution rules.

I won’t go through the details of how to perform the calculations in this newsletter, but assuming a marginal tax rate at the highest rates, Sally will owe approximately $1.3 million to the IRS once she computes the tax and interest under IRC §1291.

$1.3 million owed in tax for a pretend $1.8 million gain. That is a very high cost just to terminate the PFIC rules so your company can be taxed as a CFC only and not both a CFC and a PFIC. Remember that at this point she hasn’t received a single dollar from the company — it has made no profits and distributed nothing. For Sally, making the deemed sale election could have a disastrous effect, because the company has such a high value and the excess distribution rules are severe.

If the company stops being a CFC

If at some future point the company stops being a CFC, Sally’s holding period in the stock is treated as beginning on the day after it ceases to be a CFC for PFIC purposes only. IRC §1297(d)(3).

That means if the company stops being a CFC because, for example, Lucky sells his shares to a foreign person, Sally will potentially be able to make either a QEF or MTM election for the PFIC stock at the beginning of her holding period, if she meets the other requirements for making those elections.

Next week

Next week, after discussing what happens when David makes the deemed dividend election and the tax effects of making such an election, I will devote a portion of the newsletter to comparing the tax results for all three of our US individuals — Lucky, Sally, and David — as a wrap-up to this miniseries.

Thank you

As always, thank you for reading, and I’ll see you next week. (And please hire a professional to help you if you need advice.)